Perhaps the biggest difference between
ETFs
and mutual funds is that, unlike mutual funds, ETFs can be traded througout the day at current market prices. Every ETF has a
net asset value (NAV) that reflects what a single share is worth at a particular point in time. The NAV is determined by the total
market capitalization of the securities in the ETF portfolio, plus
dividends
or interest, minus fund expenses, divided by the number of fund shares. In other words, the NAV is not a fixed value, and moves up or down as the price of the underlying investments change and the number of outstanding shares increases or decreases.
Premiums and discounts
But the price you pay when you buy shares of an ETF or receive when you sell is not necessarily equal to the NAV. That's because the price you pay depends on supply and demand and other market forces, just as it does when you're trading individual stocks. If other investors are buying when you buy, creating greater demand, you may pay more than the NAV. And if you buy when the majority is selling, you might pay less than the NAV.
If the price of an ETF is higher than the NAV, you're buying or selling at a
premium.
And if the price is lower than the NAV, you're buying or selling at a
discount.
However, the trading price rarely deviates much from the NAV because of a unique feature of ETFs that keeps the two prices aligned. Authorized institutional investors have the right to purchase or redeem large blocks of shares at the NAV with in-kind portfolios of the fund's securities rather than with cash. That would allow them to take advantage of any descrepancy between the trading price and the market value of the underling assets. This creation-redemption process helps prevent the potentially large premiums and discounts often associated with
closed-end mutual funds.
